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We can only applaud the decision by the Peoples Bank of China this past weekend, given our consistent and regular criticisms of the yuan's undervaluation in these lines (TC 05-10-09: Central Bank Officials Raise the Volume About the Yuan!).

By allowing the Renminbi to adjust gradually against the dollar, China is positioning itself strategically as a responsible partner ahead of the G20 meeting next weekend, although there remains some real questions as to the scale of this adjustment (3%-5% per annum?).

This currency policy change will logically give a little oxygen to both the American economy, since the peg is (more or less) on the dollar, and to Europe, which is the economic zone that needs it the most, as eurozone governments launch their austerity programmes.

Let's consider the equation, GDP = C + I + G + Bal, where C = Total household consumption, I = Business investment, G = Government expenditures and Bal = trade balance.

In the eurozone's case, household consumption remains fragilised given: the level of unemployment; business investment, which continues to look outside of the zone (delocalisations); and plans to reduce government expenditures, based on the various budget reduction announcements.

As such, the only factor that could really prop up GDP is the trade balance, which is important given the importance the bond vigilantes attach to debt/GDP.

The Yuan/Euro exchange rate plays an important role in the trade balance between the eurozone and the Middle Kingdom. I have updated one of the graphs below that I have been watching for a while (TC 14-12-09: The inevitable Sino-European trade war!).

You can see in orange, in logarithmic scale, the Euro/Yuan exchange rate, and the European Union's trade deficit with China in white.

We can clearly see that the low point (1) of the euro/yuan exchange rate of near 9.50 at year-end 2005 preceded by four months the low point (1) of the lowest European trade deficit with China of $2.3bn in February 2006.

The high point (2) toward 11.20 in March 2008, preceded by five months the highest trade deficit with China in August 2008 of nearly $16bn.

And again, the euro's new low point (3) against the yuan toward 8.50 in October 2008, preceded by four months (3) the plunge in world trade in February 2009, when the trade deficit contracted sharply to $4.90bn.

Between points (3) and (4) toward year-end 2009, the euro climbed to 10.35, while the trade deficit surged to over $12bn.

Since then, the euro has depreciated by over 20% against the Chinese currency, in line with the euro's decline against the dollar, from 1.50 to about 1.20 in the past six months.

The trade deficit also began to shrink, from $12bn to $8bn, before unexpectedly climbing back up to $12bn in March.

This anomaly in March changes nothing as to the need for the euro's depreciation, and the lag effect , as seen in points (1), (2) and (3), suggests that the reduction in the trade deficit will soon occur and thus help boost European GDP.

Euro-Yuan parity and the China-EU trade balance

The adjustment will be brutal.

click to enlarge

I heard some people say this weekend that the yuan's gradual and managed revaluation could also entail the euro's appreciation. Some opposite commentators went so far as to opine that if the euro declined too much against the dollar, China would operate a depreciation of the yuan against the dollar to protect its exports to the EU.

I have a hard time taking such hypotheses seriously.

If the euro has climbed back against the dollar in recent days, it simply reflects a certain return of risk appetite and the precipitous nature of the currency's decline, which provoked the beginning of a verbal intervention and the narrowing of peripheral nation debt spreads (Spain: 220 à 170 bps).

On the contrary, we hope that international investors will remain focused on:

· the state of European public finances (in the process of improvement);

· the state of Spanish banks and that of their real estate assets (manageable in re-capitalisation);

· the risks of intra-eurozone sovereign default (is history being made before our eyes?);

· the balance sheets risks taken by the ECB (none, if the SPVs pick up the slack);

so that the euro can stabilise in a more favourable range, at around 1.10.

After all, these same investors, who can be quite fickle about their focus of concern, might also consider:

· the United States budget deficit (9.3% of GDP at 30 March, vs 6.3% at 31 December 2009 on the eurozone);

· the exposure of US regional banks to commercial real estate;

· the incredible situation of the GSEs (Cost of Seizing Fannie and Freddie Surges for Taxpayers), whose debt should be included in that of the federal government;

· default risk of municipal and state governments (In Budget Crisis, States Take Aim at Pension Costs);

· the Fed's much risker balance sheet, which is full of MBSs and other agency debt.

In conclusion, to end on a more ethical and less mercantilist note, as my call for a weaker euro might lead some to think, I have attached a second graph, comparing the changes in the euro-yuan parity with the growth differential between the eurozone and China, with help from a little Bloomberg CIX Bloomberg that I constructed and which may be shared, if you wish.

We may logically expect that the faster a country's economy grows, the more its currency will appreciate, relative to those which grow at a slower pace.

Given the investment opportunities and the difference in interest rates, the currency with the highest growth rate always appreciates the most.

Except in China's case, as you can see, because we cannot invest there directly and interest rates are also manipulated by the currency peg.

As a consequence, from 2000 to 2009, when the growth differential between China and the eurozone climbed from +3.60% (which would have already been enough to provoke a realignment of exchange rates) to +12% in 2009, the euro appreciated 60% against the yuan, from 7 in 2000 to 11.20 in 2004…

The euro only began to decline in March 2008 and, especially, in January 2010.

However, we can see that at 8.40 against the yuan, the euro today still appears to high, since it is still 18% higher than in 2000.

The China-Europe growth gap and the euro-yuan parity

The price of living in Europe under the usurper of Mr. Euro.

We shall see to what extent global exchange rates will adjust this year. In the meantime, this decision eases the sort of schizophrenic biases I had been proposing which I have changed to pro-risky assets in the near term and pro-fixed rates in the medium term.

If the yuan were to move upward in a gradual, orderly and significant way (20% to 25% on 18 months), that could even enable Europe to avoid a Japanese-style deflationist trap and lost decades.

Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Long Eurostoxx50 ETF

Source: Why the Yuan Peg Matters for Europe